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Settlement risk is the risk that a counterparty (or intermediary agent) fails to deliver a security or its value in cash as per agreement when the security was traded after the other counterparty or counterparties have already delivered security or cash value as per the trade agreement. The term covers factors incidental to the settlement process which may suspend or prevent a trade from completing, even though the parties themselves are in agreement, are acting in good faith, and otherwise competent to perform.
Risk is the possibility of losing something of value. Values can be gained or lost when taking risk resulting from a given action or inaction, foreseen or unforeseen. Risk can also be defined as the intentional interaction with uncertainty. Uncertainty is a potential, unpredictable, and uncontrollable outcome; risk is a consequence of action taken in spite of uncertainty.
A counterparty is a legal entity, unincorporated entity, or collection of entities to which an exposure to financial risk might exist. The word became widely used in the 1980s, particularly at the time of the Basel I in 1988.
A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some jurisdictions, the term specifically excludes financial instruments other than equities and fixed income instruments. In some jurisdictions, it includes some instruments that are close to equities and fixed income, e.g., equity warrants. In some countries and languages, the term "security" is commonly used in day-to-day parlance to mean any form of financial instrument, even though the underlying legal and regulatory regime may not have such a broad definition.
The term applies only to risks inherent to the settlement method of a particular transaction. Broader risks of trading such as political risk or systemic risk may interrupt markets and prevent settlement, but these are not settlement risk per se.
Political risk is a type of risk faced by investors, corporations, and governments that political decisions, events, or conditions will significantly affect the profitability of a business actor or the expected value of a given economic action. Political risk can be understood and managed with reasoned foresight and investment.
In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system, that can be contained therein without harming the entire system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries". It refers to the risks imposed by interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market. It is also sometimes erroneously referred to as "systematic risk".
One form of settlement risk is foreign exchange settlement risk or cross-currency settlement risk, sometimes called Herstatt risk after the German bank that made a famous example of the risk. On 26 June 1974, the bank's license was withdrawn by German regulators at the end of the banking day (4:30pm local time) because of a lack of income and capital to cover liabilities that were due. But some banks had undertaken foreign exchange transactions with Herstatt and had already paid Deutsche Mark to the bank during the day, believing they would receive US dollars later the same day in the US from Herstatt's US nostro. But after 3:30 pm in Germany and 10:30 am in New York, Herstatt stopped all dollar payments to counterparties, leaving the counterparties unable to collect their payment. The closing of Drexel Burnham Lambert in 1990 did not cause similar problems because the Bank of England had set up a special scheme which ensured that payments were completed. Barings in 1995 resulted in minor losses for counterparties in the foreign exchange market because of a specific complexity in the ECU clearing system.
Herstatt Bank was a privately owned bank in the German city of Cologne. It went bankrupt on 26 June 1974 in a famous incident illustrating settlement risk in international finance.
The Deutsche Mark, abbreviated "DM" or
Drexel Burnham Lambert was an American investment bank that was forced into bankruptcy in February 1990 due to its involvement in illegal activities in the junk bond market, driven by Drexel employee Michael Milken. At its height, it was a Bulge Bracket bank, as the fifth-largest investment bank in the United States.
Settlement risk may be mitigated through various techniques, including:
Delivery versus payment or DvP is a common form of settlement for securities. The process involves the simultaneous delivery of all documents necessary to give effect to a transfer of securities in exchange for the receipt of the stipulated payment amount. Alternatively, it may involve transfers of two securities in such a way as to ensure that delivery of one security occurs if and only if the corresponding delivery of the other security occurs.
Central counterparty clearing (CCP), also referred to as a central counterparty, is a financial institution that takes on counterparty credit risk between parties to a transaction and provides clearing and settlement services for trades in foreign exchange, securities, options, and derivative contracts. CCPs are highly regulated institutions that specialize in managing counterparty credit risk.
A special-purpose entity is a legal entity created to fulfill narrow, specific or temporary objectives. SPEs are typically used by companies to isolate the firm from financial risk. A formal definition is "The Special Purpose Entity is a fenced organization having limited predefined purposes and a legal personality".
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In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying." Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation or getting access to otherwise hard-to-trade assets or markets. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the New York Stock Exchange, while most insurance contracts have developed into a separate industry. In the United States, after the financial crisis of 2007–2009, there has been increased pressure to move derivatives to trade on exchanges. Derivatives are one of the three main categories of financial instruments, the other two being stocks and debt. The oldest example of a derivative in history, attested to by Aristotle, is thought to be a contract transaction of olives, entered into by ancient Greek philosopher Thales, who made a profit in the exchange. Bucket shops, outlawed a century ago, are a more recent historical example.
In finance, a futures contract is a standardized forward contract, a legal agreement to buy or sell something at a predetermined price at a specified time in the future, between parties not known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price the parties agree to buy and sell the asset for is known as the forward price. The specified time in the future—which is when delivery and payment occur—is known as the delivery date. Because it is a function of an underlying asset, a futures contract is a derivative product.
A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. These types of contracts fall into the category of derivatives. The opposite of the futures market is the spots market, where trades will occur immediately after a transaction agreement has been made, rather than at a predetermined time in the future. Futures instruments are priced according to the movement of the underlying asset. The aforementioned category is named "derivatives" because the value of these instruments are derived from another asset class.
A repurchase agreement, also known as a repo, is a form of short-term borrowing, mainly in government securities. The dealer sells the underlying security to investors and buys them back shortly afterwards, usually the following day, at a slightly higher price.
Over-the-counter (OTC) or off-exchange trading is done directly between two parties, without the supervision of an exchange. It is contrasted with exchange trading, which occurs via exchanges. A stock exchange has the benefit of facilitating liquidity, providing transparency, and maintaining the current market price. In an OTC trade, the price is not necessarily published for the public.
The Australian financial system consists of the arrangements covering the borrowing and lending of funds and the transfer of ownership of financial claims in Australia, comprising:
In banking and finance, clearing denotes all activities from the time a commitment is made for a transaction until it is settled. This process turns the promise of payment into the actual movement of money from one account to another. Clearing houses were formed to facilitate such transactions among banks.
Settlement of securities is a business process whereby securities or interests in securities are delivered, usually against payment of money, to fulfill contractual obligations, such as those arising under securities trades.
In finance, a non-deliverable forward (NDF) is an outright forward or futures contract in which counterparties settle the difference between the contracted NDF price or rate and the prevailing spot price or rate on an agreed notional amount. It is used in various markets such as foreign exchange and commodities. NDFs are also known as forward contracts for differences (FCD). NDFs are prevalent in some countries where forward FX trading has been banned by the government.
Basel I is the round of deliberations by central bankers from around the world, and in 1988, the Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland, published a set of minimum capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992. A new set of rules known as Basel II was later developed with the intent to supersede the Basel I accords. However they were criticized by some for allowing banks to take on additional types of risk, which was considered part of the cause of the US subprime financial crisis that started in 2008. In fact, bank regulators in the United States took the position of requiring a bank to follow the set of rules giving the more conservative approach for the bank. Because of this it was anticipated that only the few very largest US banks would operate under the Basel II rules, the others being regulated under the Basel I framework. Basel III was developed in response to the financial crisis; it does not supersede either Basel I or II, but focuses on different issues primarily related to the risk of a bank run.
In finance, a currency swap is an interest rate derivative (IRD). In particular it is a linear IRD and one of the most liquid, benchmark products spanning multiple currencies simultaneously. It has pricing associations with interest rate swaps (IRSs), foreign exchange (FX) rates, and FX swaps (FXSs).
Treasury management includes management of an enterprise's holdings, with the ultimate goal of managing the firm's liquidity and mitigating its operational, financial and reputational risk. Treasury Management includes a firm's collections, disbursements, concentration, investment and funding activities. In larger firms, it may also include trading in bonds, currencies, financial derivatives and the associated financial risk management.
Collateral has been used for hundreds of years to provide security against the possibility of payment default by the opposing party in a trade. Collateral management began in the 1980s, with Bankers Trust and Salomon Brothers taking collateral against credit exposure. There were no legal standards, and most calculations were performed manually on spreadsheets. Collateralisation of derivatives exposures became widespread in the early 1990s. Standardisation began in 1994 via the first ISDA documentation.
LCH is a British clearing house that serves major international exchanges, as well as a range of OTC markets. Based on 2012 figures LCH cleared approximately 50% of the global interest rate swap market, and is the second largest clearer of bonds and repos in the world, providing services across 13 government debt markets. In addition, LCH clears a broad range of asset classes including: commodities, securities, exchange traded derivatives, credit default swaps, energy contracts, freight derivatives, interest rate swaps, foreign exchange and Euro and Sterling denominated bonds and repos.
CLS is a specialist US financial institution that provides settlement services to its members in the foreign exchange market (FX). Although the forex market is decentralised and has no central exchange or clearing facility, firms that chose to use CLS to settle their FX transactions can mitigate the settlement risk associated with their trades.
ICE Clear Credit LLC, a Delaware limited liability company, is a Derivatives Clearing Organisation (DCO) previously known as ICE Trust US LLC which was launched in March 2009. ICE offers trade execution and processing for the credit derivatives markets through Creditex and clearing through ICE Trust™. ICE Clear Credit LLC operates as a central counterparty (CCP) and clearinghouse for credit default swap (CDS) transactions conducted by its participants. ICE Clear Credit LLC is a subsidiary of IntercontinentalExchange (ICE). ICE Clear Credit LLC is a wholly owned subsidiary of ICE US Holding Company LP which is "organized under the law of the Cayman Islands but has consented to the jurisdiction of United States courts and government agencies with respect to matters arising out of federal banking laws."
A clearing house is a financial institution formed to facilitate the exchange of payments, securities, or derivatives transactions. The clearing house stands between two clearing firms. Its purpose is to reduce the risk of a member firm failing to honor its trade settlement obligations.